World sharemarkets completed a rather ordinary August and that has continued into the early part of September. The global markets have experienced heightened market volatility tied to a number of factors, including concerns about China, expectations for rising US interest rates, and sharp falls in commodity prices, especially oil. Let’s have a closer look at some of these factors, and try distil the important from the noise. Sometimes it pays to have a longer term perspective on matters during periods when emotions are heightened and rationality is put aside.
China’s recent sharemarket rollercoaster has inspired anxiety across global capital markets. Since its peak in June, the Shanghai index has fallen by 43%. Yet the Chinese stock market remains 50% higher than in early 2014. Even worse, the implosion of this stock market bubble still seems unfinished. Although the performance of the Chinese market tells us relatively little about the state of the economy, ructions in the market have reverberated across the globe. This is despite the fact that the culture of sharemarket investing in China remains a relatively new speculative activity for a small urban minority. Yet during August, the main Chinese share market index fell 12%, MSCI Emerging Markets fell 9%, Australia’s market fell 8%, MSCI Europe was down 7% and the major US indices fell between 6 and 7%.
The Chinese economic “miracle” – almost four decades of exceptionally strong GDP growth averaging close to 10% per annum – is running into headwinds as it transitions from export and investment-led to a more broadly-based consumer and services economy. Sceptics see the China rollercoaster heading downhill, frightening markets, crushing the price of industrial commodities, especially oil (and from an Australian perspective, iron ore), and grinding into a dangerous hard landing. One of the biggest problems is that few know with certainty just what is going on in the Chinese economy. Official government data shows GDP growth exactly at target levels of 7%, but other indicators – from steel and copper consumption to electricity use – suggest China’s slowdown may be greater than feared.
Figure 1. China’s stock market
Source: FT, Thompson Reuters Datastream
China’s recent devaluation of its currency, the renminbi, has raised a lot of questions. While the renminbi has depreciated about 5% over a short time frame, the pace is likely to remain relatively controlled as the government incrementally moves towards a more market-driven environment. While we do not know the inner thinking of the authorities in Beijing, it is hard to imagine they will seek a massive depreciation and entertain the financial and political ramifications of such a move. Other Asian countries (Japan, South Korea, Indonesia, Malaysia and Singapore) have already experienced large declines among their currencies, whereas the level of the renminbi has remained relatively strong – but the Chinese will not want to initiate a full-scale currency war.
Other attempts by the Chinese authorities to support the market – cutting interest rates, pressuring stock holders not to sell, bullying others to buy and suspending many shares – have been clumsily enacted and failed to engender confidence. The latest crackdown on financial journalists (for “spreading rumours”) seems particularly ill-advised. But their futile attempts to support market prices are not far different from what other (Western) countries have done in similar circumstances, and one needs to put recent share price ructions in context.
A lot of attention has been given to slowing gross domestic product (GDP) growth in China. Yes, China’s growth rate is slowing, but while the percentage increases in the economy are slowing down, the actual dollar amounts are steadily going up. When China’s economy was growing at 10% in 2010, about US$844 billion was added to the economy, but with growth at 7.7% in 2013, US$986 billion was added. A rate of 7% growth is still strong, given the size of China’s economy. It should not be a shock to see growth slow.
China’s growth – slower rate off a larger base
Figure 2. China’s nominal GDP ($US bn) and real GDP growth (%)
Source: Economist Intelligence Unit, Franklin Templeton Investments
When we look at how much market panic there has been, one might be under the impression China is headed full speed into recession. That is very unlikely. While we expect moderation in China’s growth, we see it as inevitable normalisation for an economy of its size. Economic growth will moderate, and perhaps the 7% target is already looking ambitious; but the authorities retain ample tools with which to stimulate the economy, and they have the political will and means to use them. A prolonged slowdown is more likely to provoke social unrest in China than in developed economies, because stability there has been based on high growth rather than political consensus. The prospect of social unrest, in turn, raises economic and national-security concerns not raised by economic crises elsewhere, and so the stakes to augment growth by any means possible are therefor higher.
Time to keep a cool head: Value Investing 101
During periods of extreme volatility and anxiety, it pays to re-state one’s core investment philosophy and ensure that one’s approach makes sense. Let’s recognise that when investing in the stock market, there are frequent outbreaks of exuberant greed and debilitating fear driven by all sorts of factors. These events grip most participants and drive short term pricing. The timing of these mood swings and the magnitude of the pricing aberrations they generate are impossible to predict. The stock market is a peculiar place where many participants try to form a view on the immediate direction of the price of a share, or worse look backwards at where the price has been, rather than focusing on the value of the business or the market as a whole.
To value a business, we need to determine the likely profitability, the amount of that return that is distributed as dividends to owners, and the remaining part that is retained to grow the business in future years. These variables, together with an investor’s required return for taking the additional risk associated with equity investment, determine the value of the business. That is what our equity analysts spend most of their time doing: valuing businesses based on realistic and rational assumptions.
Value investing works because it is founded on the notion that Price and Value are different concepts. If one simply held the Australian stock market index from 1970 to 2015, one would have achieved a 9.85% compound return (plus associated franking post 1987). However, if you had invested capital when the market was cheap, the performance becomes significantly better. Investing on all occasions when the market has been 10%+ below fair value has yielded an average of 16.3% compounding return in the following 10 years.
Figure 3. Long term growth of listed Australian companies (MSCI Australia)
Source: Thomson Reuters Datastream
Figure 4.MSCI Australia index now trading below fundamental value
Source: Thomson Reuters Datastream
Periods of volatility are not comfortable for investors, but it is important to put these market corrections in context. Remain calm and look for potential opportunities. We don’t know for sure whether the market falls have ended, or have further to go. We would note that many of the world’s stock markets have not seen a significant correction in many years. Certainly pessimism and uncertainty prevails in markets right now, so it is possible some markets could fall further before we see stabilisation. Nevertheless, it is during these “poor” periods that the greatest opportunities arise.
Rollercoasters are fun – sharp falls on the share market are not. But value investors profit when they deploy cash during periods of weakness. We see opportunity in the current period of volatility.